What is the difference between actual overhead

and applied overhead?

In accounting, overhead usually refers to the indirect manufacturing costs. These are
the manufacturing costs other than direct materials and direct labor.

The actual overhead refers to the indirect manufacturing costs actually occurring and recorded.
These include the manufacturing costs of electricity, gas, water, rent, property tax, production
supervisors, depreciation, repairs, maintenance, and more.

The applied overhead refers to the indirect manufacturing costs that have been assigned to the goods
manufactured. Manufacturing overhead is usually applied, assigned, or allocated by using a
predetermined annual overhead rate. For example, a manufacturer might estimate that in its
upcoming accounting year there will be $2,000,000 of manufacturing overhead and 40,000 machine
hours. As a result, this manufacturer sets its predetermined annual overhead rate at $50 per machine
hour.

Since the future overhead costs and future number of machine hours were not known with certainty,
and since the actual machine hours will not occur uniformly throughout the year, there will always be
a difference between the actual overhead costs incurred and the amount of overhead applied to the
manufactured goods. Hopefully, the differences will be minimal at the end of the accounting year.

What is the difference between normal costing and

standard costing?
Normal costing is used to value manufactured products with the actual materials costs, the actual
direct labor costs, and manufacturing overhead based on a predetermined manufacturing overhead
rate. These three costs are referred to as product costs and are used for the cost of goods sold and
for inventory valuation. If there is a difference between 1) the overhead costs assigned or applied to
products, and 2) the overhead costs actually incurred, the difference is referred to as a variance. If
the amount of the variance is not significant, it will usually be assigned to the cost of goods sold. If the
variance is significant, it should be prorated to the cost of goods sold and to the work in process and
finished goods inventories.

Standard costing values its manufactured products with a predetermined materials cost, a
predetermined direct labor cost, and a predetermined manufacturing overhead cost. These standard
costs will be used for valuing the manufacturer's cost of goods sold and inventories. If the actual costs
vary only slightly from the standard costs, the resulting variances will be assigned to the cost of goods
sold. If the variances are significant, they should be prorated to the cost of goods sold and to the
inventories.
What is the meaning of fixed overhead absorbed?
This phrase is used in cost accounting and involves the assigning, applying, or allocating of fixed
manufacturing overhead costs to the units produced by a manufacturer.

Three examples of fixed manufacturing overhead costs include 1) depreciation of the manufacturing
equipment, 2) the property tax on the factory building, and 3) the salaries of the factory supervisors.
Each of these costs comes in large dollar amounts (they do not occur at a rate of say $1.00 per unit)
and none is directly traceable to the products manufactured. The dollar amount of each of these costs
will probably not change if the company produces 10% more units or 10% fewer units.

Because the fixed manufacturing overhead costs are indirect product costs (not directly traceable to
the products) the accountant allocates (or assigns or applies) these costs to the products on some
basis—perhaps on the basis of machine hours or through activity-based costing. While the
accountant assigns or allocates these costs, the products are said to be absorbing these fixed
manufacturing costs. (Absorption costing, which is required for external financial statements, means
that each product's cost includes direct materials, direct labor, variable manufacturing overhead, and
fixed manufacturing overhead.)

Fixed manufacturing overhead cost is usually applied to the products (and is absorbed by the
products) through the use of a predetermined annual overhead rate that is based on some planned
volume of production. If the actual product volume is less than the planned volume (and the costs are
as planned) the fixed manufacturing overhead will be underabsorbed. When the actual volume
exceeds the planned volume and the costs are as planned, the fixed manufacturing overhead will
be overabsorbed.

What do overabsorbed and underabsorbed mean?

In cost accounting, manufacturing overhead costs are often assigned to products by using a
predetermined overhead rate. The predetermined rate is likely based on an annual manufacturing
overhead budget divided by some activity such as the expected number of machine hours. Instead of
saying that the manufacturing overhead is assigned, we might say it
is allocated, applied or apportioned to the products manufactured during the period. We could also
say that the products have absorbed the overhead.

If the amount of overhead assigned to the products manufactured is greater than the amount of
overhead actually incurred, the products have overabsorbed the overhead costs. If the amount of
overhead assigned to the products is less than the amount of overhead actually incurred, the
products have underabsorbed the overhead costs.

The cause of the overabsorption or underabsorption will be some combination of 1) the quantity of
products manufactured, and 2) the actual overhead costs incurred.
Why use normal costing instead of actual costing?
Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to
products. In other words, the overhead rate under normal costing is based on the expected overhead
costs for the entire accounting year and the expected production volume for the entire year.

Under actual costing each month's actual costs and each month's actual production volume are used
to assign overhead costs. Since most companies will experience month to month fluctuations in
activity, the actual monthly overhead rates will likely vary from month to month.

Normal costing will result in an overhead rate that is more uniform and realistic for all of the units
manufactured during an accounting year.

What is meant by overabsorbed?

Overabsorbed is usually used in the context of a manufacturer's production overhead costs.
Since manufacturing overhead costs are not directly traceable to products, they need to be allocated,
assigned, or applied to the products through an overhead rate. We also state that the
products absorb the overhead costs through the overhead rate.

The overhead rate is normally a predetermined rate—meaning that it was calculated prior to the start
of the accounting year by using 1) the expected amount of overhead costs, and 2) the expected
volume of production. Because of these two estimates, it is unlikely that the amount of overhead
allocated, applied, assigned, or absorbed will be equal to the actual overhead costs incurred.

If the actual products manufactured are assigned or absorb more overhead through the overhead rate
than the actual amount of overhead costs incurred, the products have overabsorbed the overhead
costs.

At the end of the accounting year, the amount of the overapplied, overassigned, or overabsorbed
overhead is often credited to the cost of goods sold. The reasons are 1) the overabsorbed amount is
not significant, and 2) most of the products absorbing too much overhead costs have been sold. If the
overabsorbed amount is significant, then the amount overabsorbed must be prorated or allocated as
a reduction to the cost of the inventories and to the cost of goods sold based on where the
overabsorbed overhead costs are residing at the end of the accounting year.
What is the difference between product costs and
period costs?
A manufacturer's product costs are the direct materials, direct labor, and manufacturing
overhead used in making its products. (Manufacturing overhead is also referred to as factory
overhead, indirect manufacturing costs, and burden.) The product costs of direct materials, direct
labor, and manufacturing overhead are also "inventoriable" costs, since these are the necessary
costs of manufacturing the products.

Period costs are not a necessary part of the manufacturing process. As a result, period costs cannot
be assigned to the products or to the cost of inventory. The period costs are usually associated with
the selling function of the business or its general administration. The period costs are reported
as expenses in the accounting period in which they 1) best match with revenues, 2) when they expire,
or 3) in the current accounting period. In addition to the selling and general administrative expenses,
most interest expense is a period expense.

What is the difference between a budget and a

standard?
A budget usually refers to a department's or a company's projected revenues, costs, or expenses.
A standard usually refers to a projected amount per unit of product, per unit of input (such as direct
materials, factory overhead), or per unit of output.

For example, a manufacturer will have budgets for its manufacturing or factory overhead
departments. Let's assume that the budgeted manufacturing overhead for the upcoming year is
expected to be $1,000,000 in order to produce the expected 100,000 identical units of product. The
standard cost of manufacturing overhead per unit of product is $10 ($1,000,000 divided by 100,000
units). When the products are not identical, the $1,000,000 of manufacturing overhead might be
divided by the expected number of machine hours required to manufacture the units of product.
Assuming it will take 50,000 machine hours, the standard cost of the manufacturing overhead will be
$20 per machine hour ($1,000,000 divided by 50,000 machine hours).
What is the Difference Between Fringe, Overhead
and G&A?

Start-up government contractors are often confused by the difference between fringe, overhead and
G&A expenses. The FAR gives no substantial guidance, leaving each contractor to make their own
decisions.

Understanding these concepts will help you protect profits and give you the ability to negotiate new
contracts effectively and competitively. Being correct and consistent in how you categorize expenses
helps you effectively monitor escalating costs or eroding profit margins.

Rules for government contractors require you to distinguish and segregate direct costs from indirect
costs. Common practice is to further categorize your indirect costs into subgroups (also called
“pools”) – usually Fringe Benefits, Overhead and G&A.

Fringe benefits are costs related to employing your labor force. Examples include:

 Vacation
 Holiday labor cost
 Other paid leave labor costs (such as jury duty, family leave)
 Employer payroll taxes (FICA taxes, state unemployment taxes)
 401(k) employer match or contribution
 Health insurance and similar benefits
Overhead and G&A have a somewhat less clear definition. Overhead costs support the efforts of the
direct labor workforce, not necessarily related to a specific contract.

Common examples of Overhead Cost:

 Small business personnel commonly wear multiple hats and often need to divide their time
between many categories. Indirect labor is categorized based on what you are doing at the
time. Overhead labor might be, for example, a meeting with project managers and/or the direct
labor force that does not fall under the statement of work.
 The travel costs incurred to get you to the aforementioned meeting.
 Fees and costs associated with hiring direct employees. This could include the labor time for your
HR person to do interviews, the costs of obtaining security clearances, outside recruitment fees,
and the cost of job advertising.
 A proportionate share of total facilities costs (e.g., rent, office supplies, IT services, telephone
costs, etc.)
General and Administrative (G&A) expenses are the residual costs necessary to run a business,
regardless of whether you have government contracts.

Common examples of G&A Costs:

 Labor for strategic planning, business development efforts and to manage or perform
administrative functions
 Bonuses for people who primarily charge their time to G&A
 Professional fees, such as legal, accounting, payroll processing fees, IT services.
 Travel – perhaps in support of business development efforts
 Business insurance (general liability)
 State & local taxes (not federal taxes!)
 Conferences, business meetings
 Dues and subscriptions
 A proportionate share of total facilities costs

Fixed Overhead
Office rent, insurance, office furniture, company cars, professional memberships and other expenses that do not change
from year to year are called fixed overhead. For example, manufacturing overhead includes such things as the electricity
used to operate the factory equipment, depreciation on the factory equipment and building, factory supplies and factory
personnel that do not engage in the production of products. The mortgage payment or rent of the factory building is a
fixed overhead expense. A fixed cost remains unchanged even if the related level of activity or volume changes.

Variable Overhead
Variable costs are those that change according to changes in the level of activity or volume. Office supplies is an example
of variable cost overhead. Office supplies are considered overhead because they do not directly create revenues.
Electricity is a cost that can vary from month to month and is a variable overhead cost unless it is part of the production
process. Electricity that is involved in office lighting is overhead. Raw materials inventory is also a variable cost item, but
it is vital for the production of products and revenues, so it is not considered overhead.

Function of Overhead
A company can cut back on the purchase of office supplies, generally without harming the production of goods and
services that produce revenue. Overhead relates more to the administrative functions of an enterprise such as accounting,
human resources, clerical and managerial staff, supplies and equipment. Overhead is the organizational structure that
houses the revenue-producing activities. However, when business is slow, the best place to cut expenses is in the overhead
activities because cutting production activities has a direct detrimental effect on revenue production.

Budgeting
The difference between overhead costs and production costs is important to planning and budgeting. Fixed costs are
always identified first when creating a budget so a base cost can be established. It is often difficult to cut fixed costs either
in overhead or production. Variable costs are the difficulty that causes risk in a company by making budgeting difficult. If
budgeting is inaccurate, the company may incur costs that decrease profits. This is why variable cost control generally
results in cutback of variable overhead costs when business slows.
Traditional Overhead Cost Allocation
Identify cost driver for the overhead cost, and the total amount of cost driver in a multi-product production or multi-
service offering. A cost driver is a business activity responsible for change in a cost incurred. Suppose that a
manufacturing business has identified that the amount of production material is the cost driver for overhead cost,
consisting of machine testing, machine setup and machine cleaning. That is, total overhead cost is highly correlated with
the total amount of production material used. If total overhead cost is $10,000 and the dollar amount of production
material used for all products is $50,000, calculate the overhead cost per material dollar as $10,000/$50,000 = $0.20 per
material dollar.

Determine the amount of cost driver used in each unit of a product. Under the traditional method of overhead cost
allocation, the business allocates the overhead cost indistinguishably based on the dollar amount of the production
material consumed. To arrive at overhead cost per unit, the business needs to know the amount of material used in each
unit of a particular product. Assume that the business determines that the dollar amount of production material contained
in each unit of the product in question is $35, calculated based on the product's material cost of $35,000 and its 1,000
units. Note that total material cost for all lines of products has been set at $50,000 earlier.

Calculate overhead cost per unit. The rate of overhead cost often is expressed on a per-product-unit basis for each line of
product. Given that the material cost per unit for the product is $35 per unit and the overhead allocation rate is $0.20 per
material dollar, the overhead per unit is calculated as $0.20 per material dollar x $35 per unit = $7 per unit. The traditional
overhead cost allocation does not consider the actual amount of each overhead cost items, such as machine testing, setup
and cleaning, that a particular product needs. However, the traditional method is simple and easy to use because data on
total production material cost and unit material cost for each product are readily available being part of the direct
production costs.

Activity-Based Overhead Cost Allocation

Identify cost activities related to overhead cost. The activity-based overhead cost allocation attempts to assign the cost of
each overhead component, or activity, to a particular product to improve the accuracy of overhead cost allocation. Using
earlier assumptions on overhead cost compositions, the overhead cost derives from three cost activities: machine testing,
machine setup and machine cleaning. Suppose that the business has further concluded that the cost for each overhead
component is $5,000, $3,000 and $2,000 respectively, based on the $10,000 in total overhead cost, the same assumption
used in the traditional overhead cost allocation.

Decide on the total volume of each overhead activity. To allocate the cost of each overhead component to a particular
product, the business must solve for the cost of each overhead component on a per-activity-unit basis, which is the
component cost divided by the activity volume. Activity volumes for machine testing, setup and cleaning may be defined
as number of tests, setups and cleaning jobs. Assume that for the entire production, the business conducted 10 tests, 15
setups and 20 cleaning jobs. Thus, the unit cost for each overhead activity is as follows: $5,000/10 tests = $500 per test,
$3,000/15 setups = $200 per setup and $2,000/20 cleaning jobs = $100 per cleaning job.

Estimate the expected usage of each overhead activity for a particular product and allocate the cost of each overhead
activity to the product. Assume that the product in question required five tests on machine testing, eight setups on machine
setup and 10 cleaning jobs on machine cleaning. Based on the unit cost for each overhead activity, the amount of
overhead cost from each overhead activity assigned to the product is as follows: $500 per test x five tests = $2,500, $200
per setup x eight setups = $1,600 and $100 per cleaning x 10 cleaning = $1,000.
Calculate total activity-based overhead cost per unit. Instead of allocating the total overhead cost to a product without
considering the product's usage of individual overhead activities, the activity-based overhead allocation assigns overhead
cost at the level of actual overhead activities. To arrive at the total activity-based overhead cost allocation, simply add up
the assigned overhead cost from each overhead activity: $2,500 + $1,600 + $1,000 = $5,100. Thus, out of the $10,000 in
total overhead cost, the product in question incurs $5,100. Since the product has 1,000 in-production units, overhead cost
per unit is calculated as $5,100/1,000 units = $5.10 per unit. This is less compared to the $7 per unit overhead cost
calculated using the traditional overhead cost allocation, but it reflects more of the actual overhead cost behaviors.

Draw up a list of your business expenses. Your list should be comprehensive and include items like rent, utilities, taxes
and building maintenance, which are examples of overhead costs. Other items are inventory, raw materials and production
labor, which are not considered overhead.

Categorize each item on your list of expenses according to whether it is the result of producing a good or service. For
example, shop floor labor and the cost of raw materials are direct costs since they are incurred only when some item is
being manufactured. All indirect costs are overhead. Keep in mind that some items won’t fall easily into one category or
the other, so you must make some judgment calls. For example, most businesses classify legal expenses as overhead.
However, for a law firm, a lawyer's salary is a direct cost, since her work is directly linked to producing the legal services
which are the firm's product. Most business people find it helpful to follow the accepted conventions used in their
particular industry for classifying expenses as direct or overhead costs.

Add all of the overhead costs for the month to calculate the aggregate (total) overhead cost. You can choose another time
period, but most business people find one month to be the most useful.

Calculate the proportion of overhead costs compared to sales. Knowing the percentage of each dollar that goes to
overhead allows you to properly allocate costs when setting prices and drawing up budgets. Divide your monthly
overhead cost by monthly sales and multiply by 100 to find the percentage of overhead cost. For example, a business with
monthly sales of $900,000 and overhead costs totaling $225,000 has ($225,000/$900,000) * 100 = 25 percent overhead.

Calculate overhead cost as a percentage of labor cost. This measure is useful as an estimate of how efficiently resources
are utilized. The lower the percentage, the more effectively your business is utilizing its resources. Divide the monthly
labor cost into the total overhead cost for the month and multiply by 100 to express as a percentage.

Operating Expenses
Operating expenses, also known as manufacturing expenses, are costs associated with making a product or providing a
service. For example, if you use steel to make a product, the more products you make, the more steel you’ll buy. While
some expenses change based on the amount of product you make, such as the amount of steel needed, other expenses do
not, such as the number of machines you use to make your product. Typical operating expenses include the machinery,
materials and energy needed to make your product; packaging; shipping materials; forklifts; and any other cost you would
not have if you temporarily shut down production.

Overhead
Overhead is the expense involved in running your company and selling your product. If you stopped making your product
for a week, you would still have to pay your rent, insurance, utilities, marketing costs, administrative salaries and wages,
telephone bill, copy machine bill, Internet costs and all of the expenses related to having a company.
Pricing
It’s important to determine your production and overhead costs so you can set the optimal price for your product or
service. For example, if it costs you $3 worth of food to serve a lunch special at your restaurant, you’ll need to know what
it costs to operate your business, or your overhead, so you can put that cost, along with your desired profit, into your menu
price. If your overhead is $10,000 per month and you sell 2,000 meals per month, you’ll need to add $5 to each meal you
serve to cover your overhead costs. Your break-even point for your lunch special would be $3 plus $5, or $8. If you want
a profit of $10,000 per month, you’ll need to add $5 to each meal for a meal price of $13.

Fixed vs. Variable Expenses

While your overhead might not change as your production changes, your overhead cost per unit will. Knowing this, you
can adjust your prices as your sales go up or down. For example, if your restaurant overhead is $10,000 per month, you
will calculate a $5-per-plate overhead cost based on 2,000 customers per month. If a competitor closes or your marketing
suddenly increases your customers to 2,500 per month, your overhead will now be $4 per meal. You can decrease your
prices to make yourself more competitive, keep your prices the same to make a larger profit or increase your spending on
production or marketing.

Labor
Some businesses put all labor costs into overhead, while others divide them into administrative and production costs. If
your production labor costs increase and decrease with the amount of product you make, you might want to apply
production labor costs to your cost of production. If you have a finite number of production workers and pay them the
same wages and benefits regardless of your sales volume, you can apply these costs to overhead. If you have a sales force,
their expenses -- including salaries, commissions, mileage reimbursement, sales materials, phone expenses and
entertainment budget -- are part of your budget. Many small businesses break out these expenses as cost of sales because
they are so closely tied to the amount of product you sell.

Manufacturing Overhead
Manufacturing overhead costs are the expenses a business incurs to manufacture a product that don't fall into the direct
material, direct labor, marketing or administrative categories. They can include the cost of the warehouse building and
production machinery, the cost of utilities and upkeep for the factory, maintenance and repair costs for production
machinery and the cost of indirect labor, such as custodial, warehouse or security employees who work in the factory but
don't actually assemble the product.

Non-Manufacturing Overhead
Non-manufacturing overhead, according to the Accounting Help website, is the expense of sales, administration and
executive staff, legal and tax expenses, and other expenses not directly tied to manufacturing yet essential to the operation
of the business. Such expenses can include rent and utility expenses for non-warehouse offices, the cost of office supplies,
product distribution, advertising and accounting expenses.

Direct Labor Costs

Direct labor costs are the costs of the gross wages of the workforce who directly assemble the product being produced. In
auto manufacturing, for example, they would be the assembly line workers who put the vehicles together and touch the
parts with their hands -- hence the nickname, "touch labor." They are distinguished from indirect labor, which is defined
broadly as all other employees in the company who do not directly assemble products.

How They Are Used

A company must factor overhead, direct labor and the other costs of manufacturing into the price of its products in order
to make a profit, stresses the Missouri Small Business & Technology Development Centers. The cost categories of direct
labor and overhead are also used by accountants to calculate the relative cost and/or profitability of certain aspect of
production, and they are reported in financial statements to provide a detailed picture of the company's overall financial
health.
How are fixed costs treated in cost accounting?
Fixed costs are one of the two major inputs, along with variable costs, in cost
accounting that are used by a company's management team to determine budgets
and control expenses in relation to revenues.

Cost Accounting
Cost accounting is a business tool that management uses to evaluate production
costs, prepare budgets and take appropriate cost control measures to improve the
company's profit margins. The purpose of cost accounting is to determine a
company's production costs by examining direct and indirect costs involved in
manufacturing the company's products.

Fixed Costs
Fixed costs are one element examined in the process of cost accounting. Fixed
costs are those costs that are independent of changes in production output or
revenues. These are costs that remain relatively the same regardless of whether a
company manufactures 10 widgets or 10,000 widgets in a given month. Fixed costs
are associated with the basic operating and overhead costs of a business. They
include items such as building rent, utilities, wages and insurance. Most forms of
depreciation and tangible assets qualify as fixed costs as well.

Fixed costs are considered indirect costs of production. They are not costs incurred
directly by the production process, such as parts needed for assembly, but they
nonetheless factor into total production costs; for there to be production, the
business has to be functioning and operational, and fixed costs represent those
necessary operating costs.

"Fixed" in this context does not mean completely unchangeable, only that the costs
do not generally change based on production levels or revenue. However, fixed
costs change somewhat over time as a company makes changes or expands and
consequently hires additional personnel or acquires new facilities.

Fixed Vs. Variable Costs

The other major cost component that companies consider in cost accounting
is variable costs. Variable costs are the direct production costs that, unlike fixed
costs, do vary according to levels of production or sales. Variable costs are
commonly designated as cost of goods sold (COGS), whereas fixed costs are
expenses not usually included in COGS. Fluctuations in sales and production levels
can affect variable costs if factors such as sales commissions are included in per
unit production costs.
Fixed costs plus variable costs make up the total ongoing expenses for a company
that are examined in cost accounting for management to analyze expenses in
relation to revenues, with the goal of improving cost efficiency and profit margins.

Some companies choose to classify some costs as mixed, a combination of fixed

and variable costs. An example might be a company's electric bill, a part of which is
fixed, but a part of which varies in accordance with production; more electricity is
being used when the production machinery is running.

How do fixed and variable costs each affect the

marginal cost of production?
The total cost of a business is comprised of fixed costs and variable costs. Fixed costs and
variable costs affect the marginal cost of production only if variable costs exist. The marginal cost
of production is calculated by dividing the change in the total cost by a one-unit change in the
production output level. Marginal cost of production determines the cost of production for one
more unit of good. It is useful in measuring the point at which a business can achieve economies
of scale.

A fixed cost is a cost that remains constant; it does not change with the output level of goods and
services. It is an operating expense of a business but is independent of business activity. An
example of fixed cost is a business' rent payment. If a company pays $5,000 in rent per month, it
remains the same even if there is no output for the month.

Conversely, a variable cost is dependent on the production output level of goods and services.
Unlike a fixed cost, a variable cost is always fluctuating. This cost rises as the production output
level rises and decreases as the production output level decreases. For example, say a company
owns a manufacturing plant and produces toys. The electricity bill varies as the production output
level of toys varies. If no toys are produced, the company spends less on the electricity bill. If the
production output of toys increases, the cost of the electricity increases.

Although the marginal cost measures the change in the total cost with respect to a change in the
production output level, a change in fixed costs does not affect the marginal cost. For example, if
there are only fixed costs associated with producing goods, the marginal cost of production is
zero. If the fixed costs were to double, the marginal cost of production is still zero. The change in
the total cost is always equal to zero when there is an absence of variable costs. The marginal
cost of production measures the change in total cost with respect to a change in production
levels; fixed costs do not change with production levels.

However, the marginal cost of production is affected when there are variable costs associated
with production. For example, suppose the fixed costs for a computer manufacturer are $100 and
the cost of producing computers is variable. The total cost of production for 20 computers is
$1,100. The total cost for producing 21 computers is $1,120. Therefore, the marginal cost of
producing computer 21 is $20. The business experiences economies of scale because there is a
cost advantage for producing a higher level of output. As opposed to paying $55 per computer for
20 computers, the business can cut costs by paying $53.33 per computer for 21 computers.

Do production costs include all fixed and variable

costs?
In economics, production costs involve a number of costs that include both fixed and variable
costs. Fixed costs are costs that do not change when output changes. Examples include
insurance, rent, normal profit, setup costs and depreciation. Another name for fixed costs is
overhead. Variable costs, also called direct costs, depend on output. A change in output causes a
change in variable costs.

For example, for a boat manufacturing company, the total fixed cost is the sum of the premises,
machinery and equipment needed to make boats. This cost is not affected by the number of
boats made. However, the total variable cost is dependent on the number of boats produced.

Since total fixed costs do not change with increased output, a horizontal line is drawn on the cost
curve as opposed to an upward curve drawn to show total variable costs. The upward curve of
total variable costs shows the law of diminishing marginal returns. To calculate the total cost, total
fixed costs are added to total variable costs.

Average fixed cost and average variable cost can also be calculated to help analyze production
cost. To calculate the average fixed cost, the total fixed cost is divided by output. An increase in
production reflects a downward trend on average fixed cost, consequently reflecting a downward
slope on the curve. The average variable cost is calculated by dividing total variable cost by
output. The curve for average variable cost is U-shaped, because it first shows a downward fall
until it reaches the minimum point before it rises again, based on the principle of proportions.
What is the difference between variable cost and
fixed cost in economics?
In economics, variable cost and fixed cost are the two main costs a company has when producing
goods and services. A company's total cost is composed of its total fixed costs and its total
variable costs. Variable costs vary with the amount produced. Fixed costs remain the same, no
matter how much output a company produces.

A variable cost is a company's cost that is associated with the amount of goods or services it
produces. A company's variable cost increases and decreases with the production volume. For
example, suppose company ABC produces ceramic mugs for a cost of $2 a mug. If the company
produces 500 units, its variable cost will be $1,000. However, if the company does not produce
any units, it will not have any variable cost for producing the mugs.

On the other hand, a fixed cost does not vary with the volume of production. A fixed cost does not
change with the amount of goods or services a company produces. It remains the same even if
no goods or services are produced. Using the same example above, suppose company ABC has
a fixed cost of $10,000 per month for the machine it uses to produce mugs. If the company does
not produce any mugs for the month, it would still have to pay $10,000 for the cost of renting the
machine. On the other hand, if it produces 1 million mugs, its fixed cost remains the same. The
variable costs change from zero to $2 million in this example.

Is it better for a company to have fixed or variable

costs?
It is not necessarily better or worse for a company to have either fixed costs or variable costs. In
fact, most companies have a combination of fixed costs and variable costs.

A fixed cost is a company expense that does not change when the quantity of a company's output
changes. Therefore, fixed costs are not zero when production is zero. Examples of fixed costs
include rent, insurance premiums or debt payments. Although fixed costs are not zero when there
is no production, they can create economies of scale, where the per-unit cost to produce an item
reduces as the amount of units produced increases.

A variable cost is a company expense that varies in direct proportion to the quantity of a
company's output. Unlike fixed costs, which are not contingent on output, variable costs are
directly related to a company's level of production, rising when production volume rises and falling
when production volume falls. Examples of variable costs include the raw materials that go into a
company's cost of goods sold (COGS), packaging and salaries directly involved in a company's
production process.

A company with a larger number of variable costs when compared to fixed costs shows a more
consistent per-unit cost and therefore a more consistent gross margin, operating margin and
profit margin.
A company with a larger number of fixed costs when compared to variable costs may achieve
higher margins as production increases, since revenue increase but costs won't, but it can also
result in lower margins if production decreases.

What are the different types of costs in cost

accounting?
Cost accounting is an accounting process that measures and analyzes the costs
associated with products, production and projects so that correct amounts are
reported on financial statements. Cost accounting aids in decision-making
processes by allowing a company to evaluate its costs. Some types of costs in cost
accounting are direct, indirect, fixed, variable and operating costs.

A direct cost is related to producing a good or service. A direct cost is the material,
labor, expense or distribution cost associated with producing a product. It can be
accurately and easily traced to a product, department or project. For example,
suppose a worker spends eight hours building a car for a car manufacturing
company. The direct costs associated with the car are the wages paid to the worker
and the parts used to build the car.

On the other hand, an indirect cost is an expense unrelated to producing a good or

service. An indirect cost cannot be easily traced to a product, department, activity or
project. For example, a semiconductor company rents office space in a building and
produces microchips. The wages paid to the workers and the material used to
produce the microchips are direct costs. However, the electricity used to power the
entire building is considered an indirect cost because it appears on one bill and is
difficult to trace back to the semiconductor company.

A fixed cost is also associated with cost accounting. A fixed cost does not vary with
the number of goods or services a company produces. For example, suppose a
company leases a machine for production for two years. The company has to pay
$2,000 per month to cover the cost of the lease. The lease payment the company
pays per month is considered a fixed cost.

Contrary to a fixed cost, a variable cost fluctuates as the level of production output
changes. This type of cost varies depending on the number of products a company
produces. A variable cost increases as the production volume increases, and it falls
as the production volume decreases. For example, a toy manufacturer must
package its toys before shipping products out to stores. This is considered a type of
variable cost because, as the manufacturer produces more toys, its packaging costs
increase. However, if the toy manufacturer's production level is decreasing, the
variable cost associated with the packaging decreases.
An operating cost is an expense associated with day-to-day business activities and
may be variable or fixed. An example of an operating cost is a company's inventory.
Suppose a company produces and sells microchips. The microchips must be stored
and maintained, which is an operational cost to the company.